Earlier this month, the Associated Press reported that due to shipping snags, U.S. companies are considering a retreat from China. The article included results from a recent Kearney survey which found 52 percent of U.S. manufacturing executives have started buying more supplies in the United States in response to COVID-related supply disruptions. In addition, 47 percent said they plan to reduce their reliance on supplies or factories from a single country and 41 percent specifically indicated they want to become less dependent on China.
Since the Trump administration started toying with the idea of tariffs, we have witnessed a significant increase in anxiety over our supply chains—especially those that involve China. The state of U.S. supply chains started to deteriorate in the early days of the COVID-19 pandemic and things have only become worse since then. Now, the coronavirus resurgence resulting from the Delta variant and low vaccination rates are threatening our economic recovery. Many firms have responded by considering a return to nearshoring, as the Kearney survey results suggest, and policymakers are once again trying to strike a balance between public health and maintaining economic recovery.
Years ago, I co-authored a research paper on the Mexico-China sourcing game, the findings of which are especially relevant today. We examined how firms should allocate their orders between a near-shore supplier (Mexico) and an offshore supplier (China).
The paper found that firms' reliance on China depended on many expected factors: the cost difference, the scale and the cost of holding inventory. However, all of these have only a second-order effect—their importance diminishes as firms grow. The only factor that has a first-order impact is volatility. Every increase of volatility, no matter how slight, either on the demand side or the supply side, immediately reduces the amount firms can afford to order from China.
Volatility is impactful. If firms like to provide a reasonable service level while also keeping costs low, they must hedge against uncertainty—which could take the form of weather-related disruptions like typhoons in China, drought in Taiwan, February's Texas storms; or a demand surge, such as what we saw during the pandemic; or even other firms' strategies, as we saw with the semiconductor chip shortage. The only way to do so while still sourcing from offshore locations is by holding inventory. But, as volatility increases, so does the amount of inventory needed. So, at some point, sourcing closer to home starts to make more sense.
Volatility can also come from unexpected government laws and regulations—for example, government regulations related to COVID and travel. In fact, China has imposed sweeping new COVID restrictions in response to the Delta variant, a move that could have global economic implications. China's approach, however, is an outlier; rather than travel bans and shutdowns, most Western economies are using vaccination to keep hospitalizations and fatalities low, while keeping their economies open. For example, the U.S. has worked with Mexico to vaccinate supply chain workers. This approach allows businesses to plan their overall orders knowing that, while disruptions may occur, there is an attempt to create normalcy and keep things running as smoothly as possible.
The last few months have shown that COVID isn't going away anytime soon—we may have to learn to live with it. Over the next few years, governments must offer stability in order to allow firms within their borders to thrive. Any policy that is too harsh and unsustainable, like extended lockdowns or three-week quarantines with no regard for vaccination status, will decrease stability and add to an already volatile situation.
This is not to suggest that COVID public health measures should be abandoned. There is no simple cost-benefit analysis when human life is in the balance. But officials must understand the anxiety that mitigation measures can induce, and work to create sustainable and stable measures that balance public health concerns with economic ones. The positive impact of stability is far more significant than any tariff or regulation.
China is still the biggest exporter to the rest of the world and remains the supply chain epicenter. It's still the fastest-growing market and its capabilities and proximity to manufacturers are unmatched by any other country. But as we witness more volatile demand and supply over the next few years, we will also see a return to nearshoring. This trend started happening well before COVID, but it seems to only be accelerating thereafter.
Gad Allon is the Faculty Director of the Jerome Fisher Program in Management and Technology at the University of Pennsylvania.
The views expressed in this article are the writer's own.
